Encyclopedia of Investment Terminology

CMOs are a mortgage derivative security consisting of several classes secured by mortgage pass-through securities or whole mortgage loans. Principal and interest payments from the underlying collateral are divided into separate payment streams that repay investors in the various classes at different rates. All collateralized mortgage obligations now issued are in Real Estate Mortgage Investment Conduit (REMIC) form. REMIC classes include sequential pay tranches, planned amortization classes (PAC), and targeted amortization classes (TAC). These tranches are generally more stable than some of the tranches outlined below.

The following tranches are generally more sensitive to changes in interest rates:

Stripped Mortgage-Backed Securities - The separation of interest or principal cash flows from the underlying mortgage assets give I/Os and P/Os vastly different risk profiles. These products are highly sensitive to changes in interest rates.

Interest-Only Stripped Mortgage-Backed Securities- A pure I/O consists entirely of a premium. The value of the I/O is the present value of the future interest payments based on the underlying collateral.

Principal-Only Stripped Mortgage-Backed Securities- P/Os are generally sold at a discount, and the investor realizes a return on investment, as principal is returned at par and the discount is returned as income. (Refer to the Uniform Principal and Income Act for a discussion on determining income.)

Inverse Floaters- The coupon varies inversely to an index. As the floating rate class of securities within the issue is larger than the inverse floating rate tranche, leverage factors or multipliers are used to balance the inverse tranche with the floating rate tranches. Leverage factors or multipliers can magnify the effect of minor interest rate movements.

Prior to investing in any product, one should perform the appropriate due diligence. A copy of the prospectus and pre-purchase analysis should be retained. Subsequent evaluations consisting of total return screens, stress tests, or volatility analyses performed by management should be retained for REMICs. This documentation should support the continued investment in the product.

For employee benefit accounts, an apparent violation of ERISA Section 404(a)(1)(B) (prudence), which can be found in Section 5.H.5.c r) should be cited. The basis for the apparent violation is detailed in the DOL advisory opinion letter issued to the OCC on March 21, 1996, entitled "Investments in Derivatives." Derivatives are defined in the letter as a financial instrument whose performance is derived in whole or in part from the performance of an underlying asset. Examples include futures, options, options on futures, forward contracts, swaps, structured notes, and collateralized mortgage obligations. In that letter, the DOL opined that the products are permissible. However, trust management is responsible for assessing the inherent risks of derivatives by "securing sufficient information to understand the investment prior to making the investment." The letter discusses the importance of performing stress simulations under normal and abnormal market conditions, the effect of volatility on the plan's portfolio, and the ability to properly analyze the investment. A copy of this letter is contained in Appendix E .

Potential risks associated with such derivative investments consist of the following:

The investment is bought in a large block and several accounts hold the investment. An individual account's investment may not be liquid. For example, when an individual account needs to liquidate the asset, the question becomes how liquid is that individual account's investment. Also, is the holding in a saleable lot and at what price for a relatively small holding rather than a block transaction? However, the pricing used may be matrix pricing, which is a calculated price. While matrix pricing should be reliable under normal circumstances, the pricing does not incorporate every conceivable outside factor which may influence pricing.

Accounting systems should provide for adequate, timely and accurate pricing of derivative investments. Many pricing services do not have sufficient capability in this area. In such cases, trust accounting systems often default to the purchase price or face value of the investment. As products return principal and income, the purchase price may greatly overstate to the value, if the trust accounting system does not accept paydowns. Each CMO tranche has a factor, indicating the amount outstanding as a percent of the original face amount. Normally, these factors are available on the payment of principal and interest ticket or for FNMA issued REMICs, on the agency's website. The Capital Markets Branch in the Washington Office can provide factors and other information regarding these and other products.